Fiscal dimensions of central banking: The fiscal vacuum at the heart of the Eurosystem and the fiscal abuse by and of the Fed: Part 1

Willem Buiter08 May 2010

First published on 24 March 2009, this column is more relevant than ever. In it Willem Buiter argues that the ECB’s lack of fiscal backing is both unusual among major central banks and a severe handicap – it is a factor in why the ECB is “fiddling while the Eurozone burns” by hesitating to undertake quantitative easing started by the Fed, Bank of England, and others.

Editors’ note: This is the first of a four-part series of Vox columns culled from Willem Buiter’s recent post on his FT-sponsored blog, Maverecon.

Introduction: Why central banks need fiscal backup

Even operationally independent central banks are agents of the state. And like every natural or legal entity operating in a market economy, the central bank is subject to an (intertemporal) budget constraint. Some central banks are owned by the ministry of finance. The Bank of England, for instance, is owned 100% by the UK Treasury. The ECB is owned by the national central banks of the 27 EU member states. These 27 national central banks have a range of different ownership structures.

The Federal Reserve System is not owned by anyone. Most of the operating profits of the Fed go to the US Treasury. The twelve regional Federal Reserve Banks issue shares of stock to member banks. However, owning Reserve Bank stock is quite different from owning stock in a private company. Ownership of a certain amount of stock is, by law, a condition of membership in the system. The stock may not be sold, traded, or pledged as security for a loan – dividends are, by law, fixed at 6% per year (which is a lot better, actually, risk-adjusted, than you would get these days on stock in commercial banks).

Even though central banks can “print money” or create money electronically by fiat, they are constrained in their financial operations by two factors. First, there is a limit to the amount of real resources that can be extracted through the issuance of nominal base money. The demand for real base money is a decreasing function of its opportunity cost – the short-term nominal rate of interest. Increasing the rate of monetary issuance will raise the actual and expected rates of inflation, putting upward pressure on the short-term nominal interest rate. Empirically, at sufficiently high rates of expected inflation, the demand for real base money declines more than proportionally with a further increase in the rate of inflation: there is a “seigniorage Laffer curve”. Hyperinflations, where the inflation tax rate increases without bound but the inflation tax base goes to zero even faster, are the most dramatic example of that.

Unexpected inflation can raise inflation tax revenues. It can erode even more dramatically the real value of long-maturity nominal fixed-interest debt, private and public. But systematic surprises tend to be beyond the ken of the monetary authorities.

There is therefore a strict limit to the monetary authority’s capacity to service foreign currency debt or index-linked debt, if the only resources it has at its disposal are derived from seigniorage.

Second, a central bank with a price stability mandate is likely to be constrained in its ability to extract more resources through seigniorage by the fact that, even when it operates on the upward-sloping segment of the seigniorage Laffer curve, the real resources it needs for financial survival may only be extracted at an inflation rate well above its target or tolerance level. In that case, the central bank needs additional resources from somewhere else to meet its price stability mandate. Although in principle the source of additional capital for the central bank could be charitable donations, in practice, the central bank gets re-capitalised by the Treasury. Behind every viable and credible central bank with a price stability mandate stands a fiscal authority – the only economic entity with non-inflationary long-term deep pockets.

Fundamental problems arise when there is uncertainty about the fiscal backup of the central bank, as there is in the case of the ECB and the Eurosystem (Buiter 2008). Other, but equally fundamental problems, arise when the central bank – voluntarily or under political pressure – engages in risky financial transactions on behalf of the Treasury, but without a full guarantee from the Treasury for the losses it may incur as a result of these risky quasi-fiscal actions. This is the case of the Fed today.

Why is the ECB so timid when it comes to taking direct credit risk?

The ECB is fiddling while the Eurozone burns. Both the Bank of England and the Fed have started quantitative easing, that is, purchases of longer-dated government securities financed by increasing the monetary base, albeit on a modest scale, especially in the US. Japan, which pioneered quantitative easing, is at it again. Switzerland has engaged in a special kind of quantitative easing, involving not the purchase of Swiss government securities but the purchase of foreign exchange reserves. Such non-sterilised foreign exchange market intervention is a form of quantitative easing which is targeted specifically at the exchange rate. Sweden is about to join the club. Canada may not be far behind.

The Bank of England’s £150 billion Asset Purchase Facility gives it the option of buying up to £50 billion worth of private securities and at least £100 billion worth of government securities. The Bank of England has announced that it aims, for the time being, at making £75 billion worth of asset purchases under the Asset Purchase Facility, most of them in the form of UK government bond purchases. The Fed has announced purchases of up to $300bn worth of US Treasury securities – a small number, but a start. Credit easing or qualitative easing – the outright purchase by the central bank of private securities – has been a part of the Fed arsenal since it started purchases of commercial paper in 2008. The recent announcement that it will double its mortgage-debt purchases to $1.45 trillion indicates the scale of its ambitions on the credit-easing front. The Bank of England is expected to start purchasing corporate securities soon.

There is no sign, however, of any quantitative or credit easing by the ECB. When challenged on this, the ECB points to what it is doing. In particular, it makes available unlimited credit at maturities from one week to six months – against eligible collateral – at the official policy rate, now 1.5%. This is good, but not good enough. The maturity for which such credit is extended should be extended to one year, 18 months, and two years.

The ECB also has a very liberal definition of eligible collateral – effectively anything that does not move (and a few things that do) is eligible as collateral, as long as it originates from within the Eurozone, is euro-denominated, and is rated at least BBB-. Indeed the Eurosystem has since the crisis started accepted increasing amounts of rubbish collateral, exposing it to serious private sector credit risk (default risk) on its collateralised lending and reverse operations. For reverse transactions and collateralised lending, default risk is the risk that both the borrowing bank will default and that the collateral offered by the bank will go into default.

The Eurosystem’s willingness to provided unlimited security at the official policy rate of 1.5% has flooded the system with short-term liquidity to such an extent that the unsecured overnight interbank rate is now close to the ECB’s deposit rate of 0.5% (the deposit rate is the rate at which banks can deposit funds overnight with the Eurosystem). The difference between the effective overnight interbank rates in the Eurozone, the UK and the US is therefore much smaller than the difference between the official policy rates (1.5%, 0.5%, and 0 to 0.25% respectively).

Conclusion

The ECB/Eurosystem is hobbled severely by the non-existence of a fiscal Europe, and specifically by the absence of a fiscal authority, fiscal facility, or fiscal arrangement that can recapitalise it should it suffer losses due to credit risk assumed as part of its monetary, liquidity, or credit-enhancing policies.

It has the following policy options, provided it is willing to take additional credit risk:

Extend the maximum maturity of the fixed-rate credit (against eligible collateral) from six months to up to two years.

Engage in unsecured lending to banks, including acting as universal counterparty of last resort in the Eurozone interbank market. This is credit easing in a bank-mediated credit system – the natural counterpart to the outright purchases of private securities by the central bank in a market-mediated credit system.

Engage in quantitative easing by purchasing a basket of the 16 Eurozone government debt instruments.

For all these operations (including quantitative easing through the purchase of a portfolio of Eurozone sovereign securities), the ECB/Eurosystem ought to get a full, joint-and-several guarantee for the credit risk (default risk) involved from the 16 Eurozone national governments. Without such a guarantee, the ECB/Eurosystem can pursue its financial stability objectives only by risking its capacity to pursue its price stability mandate.

The Fed has compromised its independence and ability to achieve price stability in the medium and long term. It has done so by taking huge amounts of private credit risk onto its balance sheet without a full Treasury guarantee or indemnity. The opaqueness of many of its arrangements, facilities, and operations undermines Congressional and wider public accountability for this vast commitment of public resources.

The Fed should insist on a full Treasury indemnity for any private sector credit risk it assumes. It should also provide a full account of the ex ante and ex post quasi-fiscal subsidies and transfers it has paid to a range of mainly private counterparties.